F1 97 on the original Playstation, I was at Brazil. All I remember is I switched view to another car and decided to drive around like i was in that car, rather than my own, which was god knows where on the track. Then, a red flag appeared at the top of the screen, and before i could switch views, the finishing result screen loaded up.

No idea what happened, but thats the only time ive seen a red flag in any racing game.

yeh ive got that. it only happens when you are damaged beyond repair on the track. the finishing result was not because the race had been red flagged, rather you were out of the race because of damage. kind of pointless really then lol.

yes. and if the race did get red flagged, youd could see all the crew pushing the cars around the grid etc. and you could choose if you wanted to 'do a Kimi' i.e. get out of the car if you thought there wasnt going to be a restart, and then lose out if there was.

I can't really think of anything particularly beneficial; in the sim world, procedural realism is rather secondary to vehicle dynamics realism etc. The only situation I can think of is in a league race for example, the RD calls out a safety car near the end of a race (presuming a need for safety cars in the first place, that would be welcomed), and as it's so near the end of the race it may as well be red flagged for time limit reasons - but that said, you can set laps+time as a race length parameter so .. hm.

Project Torque's red flags are warnings for aggressive driving, similar to the real-life black and white flag.

TOCA Race Driver 3 does indeed have a great many flags; off the top of my head it has green, yellow, white, black, checkered, black/white, and the meatball flag (it's the only game I've ever seen that has that one). I believe some recent NASCAR games have the red flag w/ yellow X that indicates the pits are closed, and F1 07 (for example) features the debris flag.
I never have actually seen a racing game with a properly implemented red flag, though. Nor have I seen NASCAR's blue flag (without the yellow stripe!) or black flag with a white X, but then again I doubt even most fans know about those!